Message to fundcos: Aim a little lower

The mutual fund industry needs to re-examine its role in the financial sector and champion stewardship over salesmanship if it is to regain the trust of the Main Street investors it is meant to serve, according to a prominent industry analyst.

Speaking at the 2009 Morningstar Conference in Toronto on June 10, Don Philips, managing director of Morningstar Inc., says the demise of the mutual fund has been grossly exaggerated, as the products have proven their worth by providing investors with downside protection.

In 2008, there were nearly 2,900 American stocks that lost more than 75% of their value, out of a universe of about 10,700. At the same time, among the 15,272 non-leveraged U.S. equity funds, only one lost 75% of its value. When given the possibility of such a decline, most investors will opt for the one in 15,000 odds over one in four.

Still, he warns investors and advisors not to pay too much attention to monthly performance “leaders and laggards” lists. Many investment websites will post the daily leaders and losers, which Phillips points out serves only to “shine a light on funds” that investors are least likely to use properly.

In recent years, the mutual fund industry has come to see itself as part of the Bay Street finance industry, marketing products to retail investors across the country. But fundcos would be far better served if they reversed that model, returning to the original intention of the mutual fund, and viewed themselves as helping investors to navigate the investment universe.

That may sound like a subtle distinction. Put another way, Phillips says the current sales-based model asks, If we offered fund X, how well would it sell? The stewardship model asks, If we offered fund X, what would investors think about our company five years down the road?

“If the investor doesn’t win, everyone loses,” he says.

One of the most commonly used marketing tools is the fund’s total return chart, but Phillips points out that this data are fundamentally flawed in their application to the real world. The familiar mountain chart shows the return of a $10,000 investment over a set period, sometimes spanning decades for some of the oldest funds.

This is not very helpful, however, as it assumes that real-world investors make a single purchase and neither add to nor redeem from that position over time. In reality, most investors will add to a fund position over time via a pre-authorized investment plan, and are prone to redeeming the their holdings in the fund if it posts a poor performance.

Rather than focusing on total returns, advisors should instead pay closer attention to investor returns, which seldom come even close to following the total return chart, because investors tend to buy into funds at their peaks and sell at their troughs.

The fund itself may return a compound annual growth rate of 15% of 10 years, but if the typical investor was not actually in the fund on the upswings, the investor return may be -1.46%, as Phillips demonstrated using data for an actual (though unnamed) fund.

The gap between the on-paper total returns and the actual returns seen by the average investor is widened by volatility. The higher the standard deviation is on a fund, the more likely it is that investors will stampede in and out of it, depending on the most recent returns.

According to Morningstar data, the average sector-focused equity fund in the U.S. posted a 10-year total return of 9.53%, as of Dec. 31, 2007. But the investor return on that market segment was only 6.75%. Balanced funds, on the other hand, posted a 10-year total return of 7.80%, but because investors knew the funds were not designed to “shoot the lights out,” they remained invested over that period and actually recognized a 7.88% investor return.

Fund companies derive their greatest profits not from simply attracting investors but in keeping them over the long term. In the example cited by Phillips, the fund peaked at $119 million in 2000, and despite incredibly strong performance between 2003 and 2005 (ranging from 43.8% to 20.9%), its asset base was still only $57 million in 2008, because investors left and never came back.

By focusing less on total return and more on investor return, the fundco can manage investor expectations. That can mean flattening out the volatility of the fund. Aiming for high volatility may allow for short-term peaks, but it also opens the door to deep troughs and brings out the worst in investor behaviour.

That is not to say that high-volatility funds do not have a place in the portfolio, but they must be understood that they are designed only to provide additional growth potential and not intended as core holdings.

For the advisor, Phillips says it is important to focus the investor’s attention on the performance of the overall portfolio and not on the performance of individual investments within it. Stewards moderate the fear-greed cycle, he points out. Salesmen accelerate it.

(06/10/09)